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Month: October 2016

Global interest rates are on the rise. Those who have feared earlier in the year that Central Bankers were “cooking” the goose by keeping their accommodative monetary policies on hyper driver are being proven correct in their initial assumption. People like Jawad Mian, and Julien Brigden have been arguing that the (probably local) bottom in commodity prices we saw in January/February of this year would come back to bite the central banks in their derrières. It seems we are seeing exactly this.

To understate this important shift that has happened in the past few months cannot be understated. Just a few months ago, following the BREXIT, the world was no longer concerned that interest rates would ever rise. In fact, investors were panicking because they thought rates would never rise again! Unsurprisingly, rates started rising shortly after said consensus was reached.

Investors were buying bonds of longer and longer and duration because those bonds were rising in value fastest. Now that inflation has rebounded (albeit temporarily), these bonds are getting hit the hardest. With long term risk free rates rising, all other assets will have to readjust.

So far, what I’ve said is nothing new. Anyone with a couple charts on government bonds could easily tell you as much. And anyone falling the markets for the past year or so will tell you that the best way to make any money would be to front run the momentum, and as of right now the momentum is pushing yields higher. OPEC’s talks of a production cut have only added fuel to the fire (pun intended).

But lost in these recent moves are the larger, and more powerful forces at work pushing government bond yields lower. Perhaps most important of these forces is China’s slowing economy and the capital flight that follows.

In past articles, I have made a number of strong comments regarding any Yuan weakness but it is important to note, that the recent weakness in the Yuan is mostly due to re-surging US Dollar strength.

But perhaps even more importantly, even though the Yuan is not weakening against every other currency, the effect remains the same – capital flight has started to re-accelerate and officials are starting to panic.

Perhaps the purest way to trade Chinese Capital flight is to buy Bitcoin, which has rallied back above $700. As Chinese Authorities clamp down on other forms of capital flight such as insurance fraud, bitcoin will become an increasingly attractive form of capital flight.

As capital flight accelerates out of China, the Yuan should continue to weaken and more importantly the dollar will strengthen. A strengthening dollar will eventually weigh on the price of oil, and other commodities. Right now the inverse of the DXY (orange) and WTI are on a break, but like and Ross and Rachel they always get back together, and with the dollar set to go higher, their time apart seems quite limited. And of course that’s not including the unlikely chance of an OPEC oil cut, which although beyond my expertise seems quite unlikely. If I’m wrong, US shale will have my back to cap any oil gains at around $60.

Falling commodity prices will reinforce the deflationary trends that have been present since 2012. Which brings me back to US and global interest rates. I view the current sell off in bonds as a buying opportunity and not a top. This +35 year trend in falling interest rates is not yet over especially in the US which is still viewed and will continue to be viewed as the world’s safe haven. I still have a small position and will look to add on to it. The US 10yr getting above 2.00% would represent a strong buying opportunity, IMHO.

Now although the risk free rate of interest may be headed, lower that doesn’t mean risky corporates borrowing costs will come down, specifically junk rated corporates whose borrowing costs have fallen tremendously from the February blow out. And these bonds which are already very illiquid are held in an increasingly smaller share of hands:

The top five investment companies hold $264 billion in US high-yield bonds, according to a big report from Stephen Caprio and Matthew Mish at UBS. That’s equivalent to 20% of the market.

The top 20 hold $605 billion, equivalent to 46% of the US high-yield market, and mutual funds and separately managed accounts hold 70% of the market.

The US corporate junk bond market has become a land mine waiting for something to set it off. Potentially the biggest explosion will come from the oil companies which have benefited both from the reach for yield as well as OPEC’s misguided attempts to push oil higher. If OPEC disappoints their credit and equity looks incredibly vulnerable. Negative momentum as XLE struggles around the 38% fib retracement level from the 2014 highs does not bode well for these stocks.

A lot of these companies took on a lot of debt to maintain their dividends so yield starved investors would buy them without checking what’s going on under the hood.

As junk rated debt sells off and their cost of borrowing rises these companies could get hit extra hard.

In the end, there seem to be a lot divergences going on in the markets and yet prices haven’t adequately responded. Perhaps the clearest sign of this divergence: IMF president Christine Lagarde is calling for a December rate hike.

So far I’ve been a bit confused by the market’s sanguine response to the weakening Yuan. This goes back to a much bigger problem I’ve seen in markets lately, a growing number of disconnects. The Euro is another excellent example. With BREXIT, the European banking crisis, rise of populism, the migrant crisis, and many more problems facing the single market it is truly amazing to see the currency have a bid at all. Given massive central bank intervention it shouldn’t be surprising that the market has ceased to properly function. The most obvious result will be a heavy increase in unforeseen dislocations.

Now, it’s impossible to know when the market will start to care about the Yuan, but something tells me that the 09 peg level is going to be quite important. For now, I’m comfortable playing the role of Sam Rockwell’s character, Crewman #6.

It took a while, but 15 years after China’s inclusion in the WTO, China was able to add another notch on its geopolitical belt with the inclusion of the Yuan into the SDR and its official acceptance as a reserve currency. One can assume that this event will strengthen the Yuan, but over what time horizon? Barring, the dissolution of China, there is little doubt that the Yuan will be an important currency in the decades to come, however, we are investors and do not have the luxury of such time scales.

To just say, the Yuan’s reserve currency status will lead to a marginal increase in short term demand, is not out of the question. But once again, fails to see the forest through the trees. Certain funds, and foreign demand may rise slightly in the short term, and all else being equal, the Yuan would strengthen. But is it wise to assume “all else being equal” given a historic paradigm changing event?

I would think not. China has been artificially holding the Yuan steady to “prove” to the world that its currency is stable. Now that they have done that, and received their prize, the incentive to continue doing so, no longer exists. Well now that’s not entirely true, but all else being equal… Just kidding.

In all manner of seriousness, there are certain costs and benefits to holding the Yuan steady, and while the SDR inclusion was on the table, the benefit outweighed the cost, I argue now, that is no longer the case. The SDR inclusion was a big carrot, and with that gone the scales have tipped towards devaluation, and volatility.

For one, the big item of the day, is Chinese exports, which fell quite dramatically in September, 10% YoY. In essence, because China has been holding its currency up, it has allowed other nations to eat its growth. With the financial and economic situation as dire as it is in China, the authorities will no longer tolerate such policies.

Let’s not forget the key threshold of 6.70 USDCNY that Beijing had held since the Brexit. Before the 6.70 threshold, the PBOC targeted liquidity conditions, keeping O/N SHIBOR below 2.06%. The fact that they allowed liquidity conditions to tighten in favor of holding the Yuan steady, just shows how important a stable currency wasto them. SHIBOR was certainly spiking quite sharply, and the authorities had to do something, but the fact that they waited till after the Yuan’s inclusion in the SDR tells us a lot.

However, China’s problems don’t end with the Yuan. Even with liquidity drying up, the Chinese property bubble pushed higher, further confounding regulators who felt powerless to stop this potential systemic crisis. To show you how serious Chinese regulators are, they have teamed up Avengers style to stop the problem:

Such multi-agency coordination is one of the bright spots of the initiative, according to Ming Ming, head of fixed income research at Citic Securities Co. in Beijing. “Regulators of banks, SOEs, and industries are all parties with a stake, and should work together to solve the problem,” he said. “Otherwise deleveraging can never be truly realized.'”

With all these problems in China bubbling back up to the surface, it important to remind everyone that the Chinese capital flight story although dormant in the minds of investors never truly went away. According to a recent report by Goldman Sachs, China’s capital outflows this year may be 50% larger than “stated” by the PBOC.

As the market’s fears about a Chinese debt crisis come back to the forefront, any Yuan weakening will force the market into a risk off scenario. The irony of a risk off scenario is the strengthening of the Japanese Yen which has its own set of problems, confounding its own central planners.

It would be interesting if the PBOC was successful in forcing Japanese investors to stay in JGBs, which is exactly what the BOJ does not want. The BOJ with its yield curve target, would not be able to buy certain bonds, and may even have to taper its purchases altogether. Obviously this would be a tightening of sorts, possibly strengthening the Yen even further. Let’s not forget the havoc this would cause to the Japanese banking system.

If we go back to Brexit, the two countries most concerned about the Brexit were actually China and Japan. These Asian nations seem to be the only major countries that have a realistic grasp on the systemic nature of the global debt bubble. The free falling pound has proven their worst fears and to anyone thinking this series of events are actually unrelated coincidences fails to see the forest through the trees.

A lot of big shifts/events have transpired over the past week or so and I’d like to touch on them.

First is oil, and the potential November OPEC production cut. The market has bought the news and oil rallied quite strongly. From the looking at the chart, it’s not too hard to see an inverse H&S pattern forming. A break of 51.5 would suggest oil is going to at least last year’s highs of 61.6. But my bias is to be short oil, and long the dollar. I’m also very skeptical of OPEC’s ability to cut production for a meaningful amount of time. Saudi has the capacity to cut a little bit, but Iraq, Iran, Libya and Nigeria still have additional capacity that they’d like to bring online. I’m actually looking to short WTI. Anything above 51 is a good short in my mind but I might play it cautious and wait till it hits 52.

The problem with oil prices rising so rapidly is that interest rates which HAD fallen to record lows all across the globe have started to rebound. The relative effects from such a rise have profound implications across asset classes.

We live in a world where people buy equities for yield and bonds for appreciation.

Meanwhile, the US economic data while not good hasn’t been terrible which led to the reemergence of Fed rate hike talks. What’s interesting is the case being made for rate hikes is one of financial stability rather than an over heating economy. A growing number of Fed members are worried about the implications for staying at zero for too long. Yet another red flag for risk assets. All of this noise has led to a potential break out in the the dollar index, DXY.

For those who didn’t read last Thursday’s post on the dollar, I’ve become quite bullish due to a number of factors on top of the myriad of problems facing various banking systems around the world.

The fact that rates and the dollar have been rising together with oil is a very interesting dynamic that is not likely to last, but it may have also successfully disguised the BOJ’s “yield curve control” policy. The recent rally in USDJPY has a lot of resistance to work through before we can call this a true break out.

It’s important to note that none of this rally can be attributed to a sharp sell off in JGBs that forced the BOJ to print additional Yen. From a technical perspective, I’m looking for USDJPY to clear the 106 level and hold it. I remain skeptical that the BOJ’s policy has actually started to work. There exists a sizable speculative net long Yen futures position and these spikes may simply be a side effect of the “surprising” rate hike talks. Notice the Yen’s inability to clear a rather interesting trend line in CNYJPY going back over a year.

This could be nothing, but the economies of Japan and China are more closely linked than the markets seem to realize or care. Still important to note the positive momentum divergence in CNYJPY.

But let’s not forget gold, which has bared the brunt of these recent actions. As I said back in August, I thought the primary driver of the gold rally was lower interest rates. With rates on the rebound and a resurgent dollar, it is once again no surprise to what is causing such a steep drop in gold.

If oil continues to rise and drags bond yields with it, gold could fall even further. Also the negative momentum divergence with the price action is a little worrying. With that said, being a gold bull and an oil bear, I think the recent sell off has provided an ample opportunity for adding on to the position and I’d look forward to buying at even better price if the market offers me the chance. That’s not to say I don’t foresee an environment where rates rise against a falling oil price, but once again, that may largely depend on the effectiveness of the BOJ.

As you can see, for a global macro investor these days, there are a lot of unpredictable and irrational actors that play a significant part in the movements of markets. Not to mention the compounded effects from “the reach for yield” phenomenon. As rates rise, assets that were priced based on rates remaining low in perpetuity have to be repriced. In addition the market is working through some very important inflection points which have only added to this volatility. Going forward, it will be interesting to see how these narratives all play out.

In a recent post “Watching The Yen Like An Avian Creature Of The Predatory Nature” I suggested the Yen was near a major tipping point. As of this morning we may have been given an indication of the direction of the Yen. A strong breakout above the 10 month trend line with accelerating momentum is a very bullish signal.

“The Bank of Japan’s new framework is more significant than commonly appreciated. BoJ has voluntarily given up control of its balance sheet. Real rates will eventually plunge, prompting both bond sales to BoJ as well as JPY-negative outflows. Should more stimuli be required, the Japanese government has now been given a helicopterish carte blanche by the BoJ.”

The BOJ’s sole focus is to force investors out of the Yen and into other currencies. How do they do that? To quote from Martin Enlund again:

“With the BoJ’s intent to expand the monetary base as well as control the yield curve until inflation is “exceeding 2% in a stable manner”, it means real rates will eventually stabilise below -2%. As a result, domestic investors are likely to seek returns elsewhere and as a result sell JGBs to the Bank of Japan.”

Pretty simple eh? The BOJ has put a ceiling on long term interest rates, and abandons the ceiling on inflation, which hopefully results in much weaker domestic returns and forcing investors abroad. Or as Martin Endlund puts it:

“Furthermore,Japanese investors will likely need to take on greater credit- or currency risks, or both,”

The BOJ is forcing Japanese investors further out on the risk curve. Whether or not they will be rewarded for taking these risks remains to be seen. Yen dollar basis swaps are already deeply negative, further reflecting the high costs of converting one’s Yen into dollars.

The Yen remains a safe haven currency, and if the BOJ forces even more Japanese investors abroad, any financial shock could send those people right back into the Yen at a significant loss. The end result would be a stronger Yen, an unhappy populace, and a BOJ whose balance sheet is bigger than ever.

It’s incredibly hard to predict where this might go, but for now, it looks like the Yen has tipped its hand and is headed lower. The inverse of a weak Yen is a strong dollar, which spells bad news for gold, US treasury, and China bulls. If anything is clear, it’s that the boring summer is finally over!